Cyclical Disinflation Secular Inflation

We are on the downside of the cyclical inflation up move that started in April 2020 with negative oil prices and peaked in June 2022.  This cyclical inflation down cycle should not be confused with a return to the heyday of the Chinese offshoring / labor arbitrage era of the 2000s and 2010s.  That's not coming back unless India becomes China, and I just don't see that happening anytime within the next 10 years.

Supply and demand in the labor market is favoring workers for the first time since the 1970s.  Its a workers' market.  The aging population, with growing percent of the population retired, has kept labor force growth flat, even with population growth.  Corporations were able to fill the labor supply gap over the years by outsourcing production to China, but China's labor force is also flattening out, so that source of cheap excess labor has mostly been used up.  

A tight labor market may loosen up a bit with a deep recession, but we're not going back to the post 2008 labor market, when outsourcing to China was booming and demand for US workers was lower than supply.  Its the opposite now.  Especially for services, which can't be outsourced to China, and need a local population of workers.  That shortage of workers in services will increase their wages, which increases the cost of goods and services which are labor intensive, keeping inflation elevated.  Wage increases in the lower end of the income spectrum fuels inflation, as the bottom half of the income earners consume a huge portion of their income, unlike the rich who save and invest most of their income.  The buying power of the bottom half, boosted by higher wages, will fuel the inflationary fire as their consumption and ability to pay increasing rents keep the flame going.  

Its going to be a wage price spiral, with fiscal handouts like student debt forgiveness, gas tax holidays, and future stimmy checks and child tax credits spewing gasoline on the fire.  You have to rethink what the financial markets will be like in this secular high inflation environment.  

In a high inflation environment, bonds don't act as a good hedge for stock market volatility.  In fact, the correlation becomes more positive, so bonds act more like stocks.  And with high inflation, higher interest rates can be tolerated because everyone's cash flows increase.  Even retirees, who have cost of living adjustments baked into their Social Security payments, get bigger and bigger checks the higher inflation goes.  

But will the Fed actually take interest rates above the inflation rate, like it last did in the mid 2000s?  Highly unlikely.  There is just too much debt in the system to go back to positive real rates.  That's a fantasy now.  What blows up the system won't be allowed to happen.  Keeping interest rates above the rate of inflation will blow up the system in a zero growth rate environment.  And we are in a zero growth rate environment.  GDP numbers only will show positive readings due to the underreporting of inflation.  With accurate and real inflation numbers, organic GDP growth is around zero for the foreseeable future.  This is a function of no productivity (maybe slightly negative) growth, and very low population growth in the developed world, mostly in less productive elderly population.

In a secular high inflation environment, the go to play is to buy real assets:  real estate, commodities, and stocks that produce real assets.  The coming cyclical downturn and what I expect to be a deep recession will temporarily deflate these real assets and that's your opportunity.  I don't see a bright future for tech stocks, the thing that has been working the best over the past 13 years. 

We are in a precarious position now with cyclical and secular forces going in opposite directions, and in most cases, the cyclical forces win out in the short to intermediate term.  The next 3-4 months will show increasingly weaker economic data and that will likely help the bond market for the latter part of the year.  But that's not where the big money will be made over the next 5 years.  The big trade will be to invest in real assets and ride the inflationary wave back up, when the cyclical forces are no longer weighing down on the secular trend of higher inflation.  

Its tricky trying to time the cyclical moves, as the secular moves are longer term and easier to predict.  But I have a hard time going long commodities into a seasonally weak time period of the year as the economic data just starts to get really bad, with stocks still priced for a "softish" landing.  

On the current market, neutral on SPX at the moment, don't see much of an edge either way, would rather short rallies than buy dips as the seasonal equity weak period is coming up, which is early September to mid October.  Corporate stock buyback blackout period starts around mid to late September, so the bid coming from companies will be much lighter in a few weeks.  Also, angst over the coming winter in Europe with sky high gas and power prices, along with the continued strong dollar headwinds should keep investors from getting too bulled up.  On the other hand, the positioning data still shows hedge funds with huge futures short positions, and systematic funds with low equity exposure.  So a big plunge during this seasonal weak period is unlikely.  Thinking a move to SPX 3900 by October is possible.

Bonds really weakening over the past week, it looks like fear of a Fed overtightening and caution ahead of Jackson Hole.  This phase could last a few more weeks but the trend of higher and higher yields is unsustainable when the leading economic indicators are this bad.  So looking for a possible opportunity to get long bonds sometime in  September as the fear of an aggressive Fed gets more palpable.